that, under most circumstances, an expenditure-based index like the CPI would not accurately achieve this objective and would tend to under-index the tax system. From a cost-of-living standpoint, CPI indexation will not maintain a specified ratio of federal income taxes to the consumption spending that would yield a constant standard of living (what Gillingham and Greenlees label “direct consumption costs”).20

There are a number of reasons for this result. Some items of consumption are tax deductible: if their prices rise faster or slower than those of nondeductible consumption, a tax system indexed by the CPI will not be inflation neutral. Some items of expenditure, such as medical care, give rise to tax deductions, and some items of income, such as the imputed rent from owner-occupied housing, are tax exempt. Most importantly, during a period in which federal payroll tax rates increase, the income necessary to maintain any given standard of living in the face of price changes rises by more than the CPI. Hence indexation of bracket limits and other tax parameters by the CPI does not keep federal income taxes at a fixed ratio to direct consumption costs.

Even after a much-simplified representation of the tax code and other simplifying assumptions, neutralizing the effect of inflation requires a complex indexation formula, labeled an “exact indexation measure” (Gillingham and Greenlees, 1987). It takes into account the effects on the ratio of taxes to direct consumption costs arising from the factors listed above, the most important of which have been the indirect effects of changes in federal payroll tax rates. The formula also requires the construction of individual indexes for every consumer in a sub-sample of the 1973 Consumer Expenditure Survey in order to mimic the effect of the progressive federal income tax system.

Over the 1967-1985 period, the CPI (for the sample of households used in the simulation) rose by 197 percent and the exact index by 241 percent. A simulation of a simplified version of the statutory tax structure of 1973, with prices rising at the rate of growth of the CPI that actually occurred between 1967 and 1985, showed that the average ratio of federal income taxes to direct consumption costs would have risen by 192 percent over the period. CPI indexation would have reduced that to a rise of 13 percent, while exact indexation would have reduced it to zero. (In fact, marginal tax rates were adjusted periodically and other changes were made over the period, so that the actual ratio of taxes to gross consumption costs, without indexation, rose by 40 percent.)

The CPI is clearly an imperfect tool for indexing the income tax system. Yet despite the high rates of inflation during the period studied, CPI indexation, while not rendering the income tax system completely neutral, would have eliminated much of the bracket creep. The Gillingham-Greenlees exact index requires a

20  

Gillingham and Greenlees (1987) describe the base-weighted CPI as an approximation to a conditional COLI.



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